In a recent opinion, the U.S. Court of Appeals for the Sixth Circuit (the “Court”) ruled that penalties assessed by the state of Michigan against two debtors, stemming from fraud associated with the wrongful receipt of Michigan unemployment benefits, are non-dischargeable in Chapter 13 bankruptcy pursuant to Bankruptcy Code § 523(a)(2).1

Background Facts

In Michigan, and other states, unemployment benefits are paid pursuant to a system that relies on self-reporting and trust. Benefits recipients are paid based on representations that they are out of work and that they continue to seek full-time work. When a claimant earns income while receiving unemployment benefits, such income has to be reported, and benefits are decreased accordingly. In cases where claimants do not properly report income, the state can order restitution and assess penalties.

In this case, the Court considered the appeals of two separate Chapter 13 debtors, both of whom attempted—unsuccessfully—to have penalties stemming from allegedly fraudulent actions that led to the overpayment of unemployment benefits be deemed dischargeable in bankruptcy. In general, in a Chapter 13 bankruptcy case, a debtor can obtain a court order discharging debt if the debtor completes all payments in a confirmed plan or, in cases where all payments are not made, the bankruptcy court grants the debtor a discharge. However, there are certain exceptions to discharge enumerated in the Bankruptcy Code, including, as discussed below, those found in Bankruptcy Code § 523(a)(2) and 523(a)(7).

The Court’s Analysis

Bankruptcy Code § 523(a)(2) provides that debts based on false pretenses, false representations or actual fraud are non-dischargeable, and § 523(a)(7) provides that debts are not dischargeable if they are penalties “payable to and for the benefit of a governmental unit” that are “not compensation of actual pecuniary loss.”

Bankruptcy Code § 1328(a) provides that, in a Chapter 13 proceeding in which a debtor completes all payments under the plan, the exceptions to discharge are those enumerated in § 1328(a). Bankruptcy Code § 523(a)(7) is not one of the subsections excluded from discharge by § 1328(a), although § 523(a)(2) is excluded.

On appeal to the Court, the debtors argued that the penalties they were assessed by the state of Michigan fall under Bankruptcy Code § 523(a)(7) and not § 523(a)(2), and, therefore, are dischargeable. The debtors asserted that because § 523(a)(7) is not listed in § 1328(a), then the debts should be dischargeable.

The Court disagreed. It analyzed the applicability of the U.S. Supreme Court case of Cohen v. de la Cruz, which addressed § 523(a)(2), and stands for the proposition that, “[P]enalties associated with fraud should be regarded as essentially the same as the fraud itself and are to be included under the § 523(a)(2) exception from discharge, as debt arising from fraud.”

The debtors attempted to distinguish Cohen on the basis that the case involved fraud penalties arising from dealings between private parties, and not, as in this case, penalties levied by a government agency. The Court noted that the debtors cited no persuasive authority that supported their argument, and that the cases they did cite did not address the relationship between § 523(a)(2) and (a)(7) and, in any event, were decided before Cohen.

The debtors also argued that the debts should be dischargeable because exceptions to discharge should be strictly construed against the creditor. Again, the Court disagreed. First, it noted that even if it was to strictly construe exceptions to discharge against the creditor in this case, that does not mean it could ignore the Supreme Court precedent established in Cohen. Further, the Court explained that the presumption only operates for the benefit of “honest but unfortunate debtors.” Those who commit fraud are not provided the same “fresh start” as “honest but unfortunate debtors.”

Finally, the Court considered the debtors’ argument that, because § 523(a)(7) relates to governmental penalties, it is the more specific than the relevant § 523(a) subsections. Because of this, the debtors argued, the penalty debt “must be considered as contained solely in that subsection, thus making it dischargeable because § 523(a)(7) is not enumerated in § 1328(a).” Therefore, the Court was faced with the question of whether the same debt may be covered by both § 523(a)(2) and (a)(7).

The Court again was not persuaded and sided with the state of Michigan, and explained that Supreme Court precedent makes clear that the various subsections of § 523(a) are not mutually exclusive, and, therefore, the debt at issue in this case can be both non-dischargeable under § 523(a)(2) and dischargeable under § 523(a)(7) (because it is not specifically enumerated in § 1328(a)).

If you have any questions about this case, or bankruptcy issues in general, please contact Patricia Scott at 517.371.8132 or at pscott@fosterswift.com.

Patricia concentrates her practice in the areas of Bankruptcy, Finance, Collections, Real Estate, and Commercial Litigation. In the bankruptcy area she represents creditors and Chapter 7 Trustees in all aspects of bankruptcy. Patricia also represents small and mid-sized businesses to large corporations in multi-faceted litigation matters in state and federal court. Her work with financial institutions includes collections, loan workouts, foreclosures, receiverships and various complex banking and finance issues.